Glossary
Yield Maintenance
Yield maintenance is a prepayment premium that compensates a lender for the interest it loses when a borrower repays a fixed rate loan early. It equals the present value of the difference between the loan's interest rate and a reinvestment rate, usually a comparable Treasury yield, over the remaining term.
Formula
Example
A borrower prepays a $10,000,000 loan with a 6% note rate and five years remaining. The comparable Treasury yields 4%. The annual interest shortfall is 2% x $10,000,000 = $200,000. Discounting five annual payments of $200,000 at 4% (annuity factor 4.4518) gives a premium of about $890,364. Many loans calculate monthly and set a minimum, often 1% of the balance, but the logic is the same.
How it is used in underwriting
Yield maintenance lets a lender receive, in present value terms, the same yield it expected on the loan even if repaid early. It is common on fixed rate life insurance company, agency and some bank loans. Underwriters and borrowers model it when planning a sale or refinance: if Treasury yields have fallen since origination, the premium can be large enough to change whether an early exit makes sense. If yields have risen above the note rate, the formula can produce little or no premium, though most loan documents impose a minimum.
The details in the loan agreement drive the actual cost. Key terms include which Treasury maturity is used, whether a spread is added to the Treasury yield, whether the calculation runs to maturity or to an open prepayment date, and whether the discount rate is the Treasury yield or the note rate. These choices can move the premium meaningfully. Yield maintenance differs from defeasance, in which the borrower buys a portfolio of Treasury securities to replace the collateral rather than paying the lender a premium. Borrowers comparing loan offers should model prepayment costs under several rate scenarios, not just today's rates.
Frequently asked questions
How is yield maintenance calculated?
Determine the difference between the loan's note rate and the yield on a comparable Treasury, multiply it by the outstanding balance to get the periodic interest shortfall, and discount those shortfalls over the remaining term at the Treasury yield. Loan documents specify the exact method, including any spread or minimum premium.
What is the difference between yield maintenance and defeasance?
With yield maintenance, the borrower pays the lender a cash premium and the loan is retired. With defeasance, the borrower buys Treasury securities that replicate the remaining loan payments, the securities replace the property as collateral, and the loan stays outstanding until maturity. Defeasance is typical for CMBS loans.
When is yield maintenance most expensive?
It is most expensive when interest rates have fallen since the loan was made and when much of the term remains, because the gap between the note rate and the reinvestment rate is large and applies over many years. When rates have risen, the premium is usually small, often limited to a contractual minimum.
Related terms
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